Tom Konrad CFA
It’s Good to be Small
Small investors have an advantage over big hedge funds and other professional investors: They don’t have as much money.
Why is not having much money an advantage? It allows us to invest in stocks that large investors simply cannot touch because of lack of liquidity. If a stock only trades $50,000 worth of shares a day, a even a relatively small $50 million dollar hedge fund would have to buy all of the shares traded for two weeks just to allocate 1% to the stock, and would have to do the same if it were to sell. As you can easily imagine, that would send the stock price rocketing (or plummeting when the fund sold), and remove much potential for profit.
If the big funds can’t buy a stock, they’re not going to spend any time researching it. Likewise, analysts, who make their money selling their research to large investors, are not going to research it either. With professionals out of the picture, it’s relatively easy for a small investor to gain an informational advantage: We just have to dig a little deeper than others. The fewer investors who are paying attention, the easier that is.
That’s not to say that all (or even most) illiquid stocks are a good buy. You still have to do some digging. Yet unlike with more widely followed companies, the stock price can occasionally be much less than the value of the company, especially if that value is not yet shown on the company’s books.
Which brings me to Power REIT (NYSE:PW.) The stock’s average daily volume is about 1300 shares, or only $10,000. With a market cap of $13 million, if a $100 million dollar hedge fund tried to allocate just 1% to PW, it would send the price skyrocketing as it attempted to purchase as much stock as normally trades in five months. The fund would also end up owning over 5% of the company, becoming subject to extra restrictions on trading and disclosure.
With a stock this illiquid, even small orders of a few hundred shares can move the price five to ten percent, so it’s best to use limit orders to make sure you’re not paying a lot more than you expected. Even limit orders will move the price over time, however. That said, the current stock price of $8.10 is more than justified by the current 4.9% annual yield alone. Which means the large upside potential I’ll discuss below is essentially free.
What Most Investors See
I mentioned Power REIT in my recent article on the possibility of Solar REITs, as well as profiling the company earlier this year. I think the comments I’ve received are indicative of what most small investors see when they look at PW:
- “[W]hy [is] a relatively small and risky REIT is priced to only pay 5 percent”?
- “Suing a monster corporation when your market cap is only around $10M means your legal expenses eat your entire company value alive. “
Personally, I consider a 5% yield attractive in the current interest rate environment, but it’s the litigation with Norfolk Southern Corp. (NYSE:NSC) that provides the opportunity to dig deeper than most other investors have.
According to Power REIT’s recent quarterly report and court documents, the substance of the litigation is this:
- Power REIT believes that NSC, and its sub-lessee, Wheeling & Lake Erie Railroad (WLE) are in default on their lease with Power REIT’s wholly owned subsidiary, Pittsburgh & West Virginia Railroad (P&WV.) That leased property is 112 miles of railroad track and railroad property in Pennsylvania, West Virginia and Ohio, and is Power REIT’s main asset. For the sake of brevity, I will refer to NSC and WLE collectively as the lessees from this point forward.
- The lessees are seeking a judgment that they are not in default of the lease. If they are not declared in default they have the right to unlimited renewals of the 99-year lease on the current terms which are very favorable to them.
- If the court declares the lessees in default, they would have to re-negotiate terms for using P&WV’s property. In addition, a substantial “indebtedness” arising from tax payments made by P&WV on NSC’s behalf and asset sales of unused portions of the leased property would come due. The court may also declare the lessees owe back interest on the indebtedness. NSC has not provided access to the books which would document the size of this indebtedness, but it was carried (without interest) on P&WV’s 2009 tax return (prepared by NSC) at $15,517,325. It has since increased to at least $15,882,651, according to an exhibit filed by Power REIT. The lessees refer to this indebtedness as the “settlement account.” The lease limits the size of this indebtedness to a tiny fraction of the size of the current settlement account.
- P&WV believes that the lessees are in default for at least three reasons, which they state in their answer legal filing:
- Failure to pay specific P&WV’s legal fees which it believes the lessees were required to pay under the lease after 60 days notice.
- Failure reimburse P&WV in cash for Federal tax payments made under the terms of the lease.
- Failure to allow P&WV to inspect books and records regarding its property or inspect its track.
Payment of Legal Fees
The lessees argue that the lease does not require them to pay P&WV’s legal fees. The relevant section of the lease, 4(b)(6), states that the lessee is
[R]equired to pay all obligations reasonably incurred by [P&WV] … for … all acts and things necessary or desirable for the protection [of P&WV]’s rights …. pursuant to this Lease, except such obligations … solely for the benefit of its stockholders.
While I’m not an attorney, it seems clear to me that the legal fees Power REIT has incurred to determine its rights under the lease and to protect its interest in the current litigation are both “necessary or desirable” to protect its rights under the lease. While everything Power REIT does should eventually be for the benefit of its stock holders, that clause is not relevant here because, as P&WV points out in its legal filings, NSC has not historically applied that exemption to paying any of P&WV’s taxes. These tax payments are also required under the lease subject to the same exemption.
Payment of Taxes
The lease allows the lessees to use the depreciation of the property to reduce their tax bills, so long as they compensate P&WV for the taxes then owed. Section 4(b)7 of the lease states such taxes (as well as the legal fees discussed above) “shall be paid or discharged by Lessee as and when they become due and payable.”
Rather than paying these taxes for P&WV, the lessees have simply been increasing their “indebtedness” to P&WV, as discussed above, forcing P&WV to pay the taxes out of its own cash. This is another reason Power REIT argues that the lessees are in default.
Pittsburgh and West Virginia Railway Route Map, pre-1967 from Wikipedia
Refusal to Allow Inspections
NSC has also refused to allow Power REIT to inspect NSC’s books, despite the fact that section 8(a)3 of the lease seems crystal clear that it should be allowed to do so:
[NSC and WLE] shall permit at any and all reasonable times such person or persons as [P&WV] may designate to inspect the books and records of [NSC or WLE] for any purpose whatsoever.
As far as I can tell, the track inspection Power REIT requested is not required by the lease, but the refusal to allow an inspection of NSC’s books seems sufficient to declare NSC to be in default.
A portion of Wheeling and Lake Erie Railway’s Route Map
Timing and Likely Outcomes
The case is pending in Federal Court in Pittsburgh, PA. The litigation is currently in the active discovery phase. While it’s extremely difficult to predict how long the litigation might continue, and what the cost might be, both parties are asking the court for a summary judgment, which means that there could be a judgment soon after this phase is over.
The various issues that will need to be decided are:
- Can Power REIT terminate the lease?
- How should the “indebtedness” in the settlement account be treated?
- Are the lessees responsible for any of Power REIT’s legal costs?
From reading the filings, it seems to me that WLE and NSC’s strongest argument is that they have been doing things this way for 45 years, and P&WV has never objected before. Hence, the argument goes, P&WV implicitly agreed to their procedures with its lack of objection over four decades. Power REIT’s counter is that P&WV was for all intents and purposes a captive of NSC. NSC controlled PW’s board (WLE’s President was chairman of the board.) NSC even prepared P&WV’s taxes. Since P&WV did not have the capacity to object, its previous silence did not constitute assent.
Termination of the Lease
It seems clear to me that WLE and NSC are in default of the lease on several counts, and the lease is quite clear that there is no remedy once a default has occurred. That said, the court might still decide that the possibility of economic disruption would be too great if Power REIT were allowed to completely revoke the lease, and so might simply change the terms of the lease, or order that they negotiate a new lease that the court deems fair.
Any of these outcomes would most likely be favorable to Power REIT, since the current lease has no provision for inflation, past or future, and the current rent is far below a market rate. The worst-case scenario for Power REIT would be if the court were to rule in WLE and NSC’s favor, and re-affirm the status quo.
If the court finds the lease in default, then WLE or some other railway will need to renegotiate a lease with Power REIT. Given the fact that the current lease is 50 years old and has no inflation adjustment, it seems reasonable to expect that any new lease would be considerably more lucrative for Power REIT than the old one. It’s also worth considering that the rail in question lies on top of the active Marcellus Shale natural gas play. While the environmental impacts of shale gas drilling are in question, the impact on rail usage are not: shale gas drilling requires incredible volumes of water, sand, and drilling chemicals to be hauled, and rail is far more economical for moving bulk goods than roads. Any new market lease would probably be worth many times the $915,000 per year ($0.55 per PW share) paid under the old lease.
The lease does not define the terms of the “indebtedness” represented by the almost $16 million in the “settlement account,” and is silent on when the indebtedness is due. PW argues that because the lease is silent on the matter, the money is payable on demand.
Even if Power REIT is not able to demand the money immediately, the lease caps the settlement account at five percent of P&WV’s assets, which, depending on how assets are valued, is almost certainly less than $1 million.
Hence, there are a large number of avenues by which the court might decide that at least $15 million of the settlement account is due and payable immediately. Since Power REIT has only 1.62 million shares outstanding, that amount to a payment of over $9 a share. As I write, Power REIT’s stock last traded at $8.10.
In any case, the court may decide that the balance is subject (as Power REIT argues) to interest at the Applicable Federal Rate (AFR). I was only able to find AFR data back to 1990, but the long term AFR appears to be about 1% less than the 10 year Treasury rate for those years, so I used this approximation for 1967 to 1989. If we assume that the settlement balance has accrued in straight-line fashion over the 45 years since the beginning of the lease, we get a total (with compounded interest) of around $70.7 million.
While the legal argument that a debt should accrue interest seems sound to me, I have trouble believing that the court would award $70 million to a company with a $13 million market cap. On the other hand, much stranger things have been known to happen.
Payment of Legal Costs
The lease seems quite clear that the lessee should pay all P&WV’s tax payments and legal costs that are not strictly for the benefit of shareholders.
The legal costs are disclosed in Power REIT’s 10Q, and amount to $366,000, or $0.23 a share. Although these legal costs are recoverable under the lease, GAAP accounting rules require them to be booked as an expense, and this has
been depressing earnings over the last few quarters. There was also a smaller amount spent in 2011.
Power REIT management believes that the lessees will have to reimburse these legal fees. This confidence makes this tiny company willing to take on a behemoth like NSC in a legal battle. The expense might be hurting the stock now, but the cost is much easier to bear when it’s likely your opponent will be paying your expenses. This also means the lessees have an incentive to wrap the case up quickly.
When the case is over, the worst case scenario is that the court decides NSC will not have to reimburse any of these expenditures or taxes. In that case, the bleeding will stop, and PW’s earnings per share will return to their former level of about $0.44 a year based on the rent from the lease. Otherwise, we will see a one-time earnings boost of $0.23 a share or more, some of which might have to be returned to shareholders as a special dividend in order for Power REIT to retain its REIT status.
Implications for Power REIT
This litigation has so far prevented Power REIT from progressing with its plans to diversify its business into Renewable Energy Real Estate. I have also spoken to multiple investors who are unwilling to invest in the company until the dispute is resolved. I think such investors are being overly cautious.
Potential moneys that the lessees might be ordered to pay are
- $0.23 per share or more in legal fees. I think this is very likely.
- $15,882,651 or $9.80 a share for the value of the settlement account. I think there is a decent chance that the court will order NSC to pay this one way or another, although it might not come as a lump sum.
- Interest on the above amount. If the court does award interest, it would come to about $55 million ($34 per PW share) of compound interest on top of the $15.5 million principal if they use the long term AFR.
- Increased rent under a renegotiated lease, which could be many times the current lease payment. The current lease pays $915,000, or $0.56 per PW share per year.
The downside for Power REIT would simply be that the court orders that the status quo be maintained (in which case they could still order the lessees to reimburse Power REIT’s legal fees.) In this case, the legal spending will stop, investors will have greater certainty and still own a REIT yielding over 5% which has plans to expand its asset base into renewable energy real estate. As I have previously written, that expansion is likely to allow PW to increase its per share dividend.
In addition, Power REIT could write off the noncollectable settlement account against future income. This has been carried on Power REIT’s tax returns as a receivable.
While no cash would change hands, writing off the $15,882,651 against future income would allow Power REIT to return $9.58 per share to shareholders as a tax-exempt return of capital, rather than as unqualified dividends. At the current quarterly dividend rate of $0.10 per share, that would mean that all Power REIT’s dividends would be exempt from tax for the next almost 24.5 years.
With the stock price at $8.10, PW’s annual yield is 4.9%. While the write-off would make no difference to a tax-exempt investor, a taxable investor in the 30% tax bracket would get an after-tax income stream comparable to another REIT yielding 7%, a substantial difference which I do not believe is yet priced into the stock.
Normally, I would suggest that any investor with the option should purchase a REIT in a tax-advantaged account, such as an IRA. In this case, if you think the chances of Power REIT being able to collect on the indebtedness are low, a taxable account would be most appropriate.
Heads: Win Big, Tails: Win Small
PW is a $8.1 stock carrying no debt whose price can be justified on the basis of current assets and dividend alone. On top of that, it has a decent (in my opinion) chance of a legal victory in 2013 that could result in payments significantly in excess of the company’s entire market capitalization. If they lose, they can still write off the noncollectable $15,517,325 settlement account, allowing the company to characterize distributions to shareholders as non-taxable capital gains for many years to come.
That’s an investment even a large investor would love… if only they did not have too much money to buy it.
Disclosure: Long PW.
DISCLAIMER: Past performance is not a guarantee or a reliable indicator of future results. This article contains the current opinions of the author and such opinions are subject to change without notice. This article has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.